InvestorsFriend Newsletter March 26, 2022

Investors – Prepare for Higher Interest Rates

We have liftoff!

It now seems clear that the four decade period of declining interest rates is finally over. Central Banks in Canada, the United Kingdom and the United States have all started to raise interest rates and have signaled that fairly significant increases are coming over the next year or two. That should worry stock investors.

Interest rates as set in the bond market have already moved up significantly. Since January 1 the yield on the ten year U.S. Treasury bond has increased from 1.72% to 2.48%. And the yield on a five year government of Canada bond has doubled from 1.25% to 2.51%.

Financial theory and math is crystal clear that higher interest rates act as a gravitational force on stock prices. It’s possible that higher profits will offset that and stock prices will continue to rise. But investors should not be surprised if stock indexes such as the S&P 500 decline as interest rates rise. In fact, it’s to be expected.

A reasonable defense against this possibility is to hold a higher proportion of cash and short-term fixed income investments. This will provide funds to invest in equities if their prices drop due to higher interest rates.

Investors that agree that interest rates will move materially higher should reduce their holdings of long-term bonds if they hold any.

It may also be possible to select stocks or sectors that will do better than most in a rising interest rate environment.

In short, higher interest rates may become the story of the markets in 2022 and investors should prepare accordingly.

An Instant Balanced and Globally Diversified Portfolio

A great portfolio for anyone getting started investing and arguably even for experienced investors is to set up a balanced globally diversified portfolio using low-fee Exchange Traded Funds. In fact there are some Exchange Traded Funds that offer this in a single fund. I recently updated my article that provides the stock symbols to accomplish this. I included a suggested approach to specifically deal with expected higher interest rates. I also include more sophisticated approaches that use several Exchange Traded Funds. In all cases these portfolios can be purchased in minutes and thereafter require very little attention.

Warren Buffett’s latest Annual Letter

Literally millions of investors eagerly wait for and then devour Warren Buffett’s annual letter to shareholders. Why? Because it is always full of the finest pearls of investment wisdom to be found. It’s also always an easy read .

So let’s take a tour thorough this year’s letter which was dated February 26, 2022.

You see the full letter at www.berkshire.com or click this link directly to the letter.

First up is the table that compares the rise in Berkshire Hathaway’s share price with the performance of the S&P 500 index with dividends on the index reinvested. The comparison period is for the 58 years ended September 30, 1965 (the year Warren Buffett took control of the company and ousted the former management) through to the end of 2021.

The table shows that Berkshire’s share price has compounded up at 20.1% per year while the S&P 500 including reinvested dividends has compounded up at 10.5%. Berkshire has not paid any dividends during that entire time except, strangely enough, one thin dime per share in 1967 which is ignored in the comparison.

Okay, so with Buffett at the helm, Berkshire has compounded up at a percentage return 91% higher or close to double that of the S&P 500. That sounds impressive but perhaps not earth shattering.

But the bottom line in the table shows us the amazing power of compounding a higher return over 58 years. The S&P 500 has gained an impressive 30,209% over those years but Berkshire’s stock price has risen a staggering 3,641,613%. So Berkshire has outperformed by 121 times! Stated differently $1000 invested in the S&P 500 on September 30, 1964 is now worth $303 thousand dollars while the same $1000 invested in Berkshire on the same date is now worth $36.4 million dollars.

Some of you will be thinking, okay but what about inflation? Indeed, inflation during those 58 years has eroded the purchasing power of a U.S. dollar by a withering 87%. So, in real terms, after inflation, $1000 invested in the S&P 500 on September 30, 1964 is worth $39 thousand dollars while the same amount invested in Berkshire shares on the same date is worth $4.7 million dollars.

Anyway you look at it, the rise in Berkshire’s share price under Warren Buffett’s management has been spectacular and dwarfs that of the S&P 500 which itself was already an exceptionally strong investment.

Treating all shareholders equally

“Charlie Munger, my long-time partner, and I have the job of managing a portion of your savings. We are honored by your trust.

Our position carries with it the responsibility to report to you what we would like to know if we were the absentee owner and you were the manager. We enjoy communicating directly with you through this annual letter, and through the annual meeting as well.

Our policy is to treat all shareholders equally. Therefore, we do not hold discussions with analysts nor large institutions.”

So, Buffett treats all shareholders equally. Virtually every other publicly traded company treats large institutional owners and stock analysts far more favorably. They hold meetings for those people. They take questions from them. Top management spends countless hours dealing with only the biggest owners and the stock analysts. Buffett has always refused to do that.

Berkshire picks businesses, not stocks

“…our goal is to have meaningful investments in businesses with both durable
economic advantages and a first-class CEO. Please note particularly that we own stocks based upon our expectations about their long-term business performance and not because we view them as vehicles for timely market moves. That point is crucial: Charlie and I are not stock-pickers; we are business-pickers.”

This is an important mindset. Buffett never invests by looking at the history of a stock’s price changes. He looks as the earnings history and future potential. There is a huge difference in mindset when we see ourselves as owners of businesses as opposed to stocks (mere squiggles on a screen).

Berkshire’s success has been good for America and vice versa

“Berkshire owns and operates more U.S.-based “infrastructure” assets – classified on our balance sheet as property, plant and equipment – than are owned and operated by any other American corporation. That supremacy has never been our goal. It has, however, become a fact. … Berkshire always will be building.”

That’s an interesting fact. Much of the infrastructure Berkshire owns would have existed and been owned by others if Berkshire did not buy the railroad and utility companies that it owns. But, remember, Berkshire does not pay a dividend and instead has plowed billions into needed new infrastructure that the previous owners of those businesses may never have done. That’s been good for Berkshire and for America.

Buffett details how Berkshire Hathaway was formed by the merger of the Berkshire and Hathaway companies in 1955 and how poorly it performed in the following ten years prior to Buffett taking it over. This led to not much income tax being paid to finance the government.

“All told, the company paid the government only $337,359 in income tax during that period – a pathetic $100 per day.” And now? “Now, Berkshire pays roughly $9,000,000 daily to the Treasury.” (That’s 90,000 times more per day!). “Absent our American home,
however, Berkshire would never have come close to becoming what it is today. When you see the flag, say thanks.”

Buffett never complains about paying income tax and always gives ample credit to the nature of the American economic system that makes his success possible..